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Before You Think About Investing in America's Oil Glut, Consider This...

Low oil prices have prompted some companies to pause production; tune in to learn what it means for energy investors.

As oil prices remain low, some U.S. companies are reacting by simply leaving oil in the ground. This energy edition of Industry Focus examines what this says about the companies that make that call, how the move could affect future oil prices, and what it all means for services companies.

Meanwhile, low oil prices have some investors looking to companies that offer oil storage. Taylor and Tyler reveal the one key thing Foolish investors need to know before making oil storage capacity a major part of any investing thesis.

A full transcript follows the video.

Taylor Muckerman: Well, it looks like we know what Warren Buffett did with all that money he sold ExxonMobil(NYSE:XOM) shares for.

Tyler Crowe: Yes. I didn't really see that one coming, but hey. I guess if you're going to combine something like Heinz and Kraft together, you might as well drop ExxonMobil while you're doing it. I don't know!

I'm still burned by it. I feel kind of bad. I didn't think he actually did it, but then he actually did. I was like, "Oh man, I guess I don't know what he's doing as much as I thought I did."

Muckerman: We all try to predict it, but that's enough of the consumer goods talk! We're not selling energy. Let's pick it up with Industry Focus today, energy style.

Crowe: Yes let's get things started off, because everyone wants to talk about it nowadays. It is too much oil. America's got it coming out our ears, and we don't know what the heck to do with it, so right now we're even keeping it in the ground!

The new big term of the week, or the month, you might want to call it, is the "fracklog," and that is the amount of wells that are being held back from production. Basically, they've drilled it, they've got it ready to go, but they haven't actually done the hydraulic fracturing process yet, so it's not ready to flow oil.

There are a ton of companies out there; EOG Resources(NYSE:EOG) has been one of the pioneers of this idea for the year, saying, "We're not going to complete these wells because we don't see the point of actually letting them go, because oil's so cheap there's no point."

Muckerman: That's right. This is a company that I don't think really has to prove itself anymore. It's had years of double-digit production growth. This year they're saying, "We're not going to concentrate on production growth. We're going to concentrate on returns."

If oil does reach back to $65, they said that double-digit returns are well within their grasp, as well as double-digit production, so they're just going to scale that back a little bit.

The reason why is because the fracking stage is the most expensive stage, typically, in the drilling process, so they're just getting these wells ready, priming them, and all they have to do is go in there and do this service-intensive step, and then the oil starts flowing again.

I think this kind of puts a ceiling on some of the oil prices that you're going to see over the near to mid-term, because they're one of the lowest-cost producers.

If they turn on the gas and the oil once prices hit a certain level, they could just keep it at that certain level without letting it rise any further, because that increase in production will have a meaningful impact because that supply and demand balance is so tight and they're the largest shale producer in the United States.

They're not the only company; there's a huge list of these guys out there that are saying, "We're going to drill up to the completion stage and then just pause until oil reaches a level we feel comfortable with." Not everyone's doing this, but some of the biggest names in the business are.

That worries me in terms of oil prices achieving a higher level, because once they reach a reasonable level, production is going to pick back up and then prices could be capped for a decent amount of time unless demand decides to get its act together and fill the gap there, which could be a year, two years from now; maybe never.

Crowe: Who knows? There are two interesting snippets on that. First off, the idea that yes, it could keep oil prices from soaring too quickly, because when you have that much backlog in line, ready to go ...

Actually, the most recent study done by Wood Mackenzie estimates there are about 3,000 wells in the United States that are currently waiting; not producing, but just ready, waiting to go.

If you do the initial production numbers on those, which for most of these wells is somewhere between 750 or 1,000 barrels per day on that initial production, that means that there are 3 million barrels per day of initial production, just ready, waiting to go.

Muckerman: It's a pretty meaningful amount.

Crowe: That's a lot of oil we're talking about here. Now granted, those are initial production numbers. If you have been looking at what goes on in the oil and gas industry as of late, initial productions are really, really high and it drops off really quickly; so don't immediately think that we've got 3 million barrels per day just ready to turn on in perpetuity.

Muckerman: Right.

Crowe: That's just a quick jolt that we could add to the market.

There is a lot there, and like you were saying it could extend lower prices for a little bit longer than some of us maybe had hoped.

I think one of the things that you could maybe take away from this as an investor, more looking on the long-term sort of thing; what I like to see is that there are companies out there that have the financial flexibility to actually make this move.

Muckerman: Right.

Crowe: There are a lot of companies out there that just have to drill. They're like, "We have to pay the bills, and the only way we can do that is to bring something online."

When you have a company like an EOG Resources or some of the other ones that were mentioned doing this, such as Anadarko Petroleum(NYSE:APC) or somebody like that, it should be reassuring as an investor to look at that and go, "Okay. They feel like they have the flexibility to turn it on when they want, when they feel like they can get a better return."

To me, that's a sign that they're in a much better financial position than anybody else. It might make me want to lean toward one of them, versus somebody who has to keep the taps running.

Muckerman: Yes, the companies that are just tossing cash at this are essentially burning future cash flows, which is what EOG and Anadarko, and maybe even a Devon Energy, the list is pretty long.

Not as long as the list of companies that aren't financially solvent for a long period of time, but those are the companies that you want to focus on right now; not just in the time of strife in the oil industry, but overall because you know in a cyclical industry, over 10-15 years this is going to happen again, and maybe again, and maybe again, but they're not going to be hurt nearly as badly.

Just look at the stock charts of those three companies I just mentioned, compared to even an ETF for the energy sector. They're outperforming over this timeframe, since last June.

One other quick point; maybe services companies. They've been hit a little hard because people are pulling back, trying to put some pressure on the pricing that these service companies can charge. But as I said, fracking is one of the most expensive parts of the drilling process, so once they have to clear out those 3,000 wells they could be back in business.

Granted, it's a short-term pop, but it is just a backlog for them too, even though they're not the ones really holding that on their asset balance sheet.

Crowe: Yes, and just keeping to that long-term -- this is cyclical, this stuff happens, it comes and it goes -- one of the really popular things we're seeing a lot lately with this oil glut is we've seen a few articles and experts out there looking at oil storage, saying, "This is the next great move for people. Anybody that owns a tank is going to be somebody that's doing really well right now."

If we look at storage today in the United States, we have about 375 million barrels of capacity in these tank farms, which are these massive fields of oil storage tanks where we can hold a bunch of stuff.

As of today, there are about 260 million barrels of oil sitting, just hanging out, waiting for the right time. We have a lot in storage. We are not completely running over yet; I think some people may be slightly overreacting to this.

But the biggest thing, that is the overall takeaway from this -- when people are suggesting, "We should go buy these storage companies" -- this is the thing that you really need to consider when you're thinking about that:

Companies that we're talking about here, yes, they're great companies. You might be able to add that as a little bit of the investing thesis, but certainly you don't want to use that as your entire investing thesis because one of the big things that you have to know about oil storage is that it is a long-term contracted position.

Just because they're getting a little bit more, does not necessarily mean that you're going to see a huge bump in revenue or in earnings or anything like that. A great example is somebody like a Magellan Midstream Partners (NYSE:MMP), one of the larger oil storage companies in the country right now.

Oil storage is not the primary component of their revenue or their income. It gives them a nice little boost, but at the same time a majority if not all of their oil storage is based on these long-term take-or-pay contracts.

If you're going in and looking at somebody like a Magellan Midstream Partners and saying, "I want to buy them for their oil storage," you're probably going to be a little bit disappointed come earnings time, when they're just saying, "It just happened to perform exactly how we thought it would." It's not going to be this major blowout.

Muckerman: These are pretty predictable businesses, and that's why they pay predictable dividends, which is why people invest in them for the most part.

As you said, if a company has enough spare capacity to grow from this, they probably haven't been doing very well for the last year or more because that means that their capacity hasn't been contracted out.

Like you said, most of these are 5, 10, 20-year contracts where these oil companies have to pay for the capacity they're buying, regardless of if they're filling it or not.

When you look at a company like a Magellan or an Enbridge (NYSE:ENB), they probably don't have much wiggle room to add any contracts, but if they do you can bet that they're probably trying to add 6 months to a year.

For this near-term glut, this isn't a market-mover, in my mind, for these companies. If it is, then the company might not be the best long-term investment because if you look at the chart on EIA.gov, oil storage bounces around.

We are at a peak right now, but if you look back to just January of 2013, when Keystone XL's southern leg came on, storage in Cushing, which is where West Texas Intermediate is priced in Oklahoma, fell off the map because it had greater access, prices were riding high.

Once you see prices rebound again, you're likely to see storage fall because companies are just waiting it out before they start to release this, because who in their right mind is going to sell oil at $40 a barrel when the futures prices are much higher than that?

Granted, that's not realized because that is in the future. That's a prediction, but it makes sense to hold back a little bit, and right now we're holding back at record levels.

Crowe: Once again, the overall thesis that we have whenever we do one of these podcasts and talk about one of these trends that seems to be really hot, and people are talking about it, you just have to look back and go, "Guess what? Over the really, really long term, these things don't matter as much as everybody might claim they do."

Muckerman: That's right.

Crowe: Invest accordingly.

Muckerman: Agreed.

Crowe: With that, we would like to thank you for tuning in today. Just like with all of our podcasts, some of the people talking -- myself and Taylor today -- may have interests in some of the stocks we have mentioned, so don't buy or sell anything that we've said based solely on what you've heard today.

We'd love to hear from you. Send us an email, tell us how we're doing, at industryfocus@Fool.com. I'm Tyler Crowe, talking with Taylor Muckerman today on Industry Focus. Thanks for listening!

Author

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Taylor is an Associate GM in our Fool International operations. Prior to that he covered all things Energy + Materials as an analyst. Over the years, he has built an investing skill set to rely on when evaluating companies inside and out. While at the Fool, he has made appearances on CNBC and Fox Business. In addition, he completed his MBA at the University of Maryland and will sit for the Level II CFA Exam.